**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

**x****                    ****QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**

For the quarterly period ended March 31, 2006.

OR

**o****                      ****TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**

For the transition period from                             to

**Commission File Number: 1-11388**

**PLCSYSTEMS INC.**

*(Exact Name of Registrant as Specified in ItsCharter)*

 

| **Yukon Territory, Canada**                 |   | **04-3153858**                          |
|---------------------------------------------|--------|-----------------------------------------|
| *(State  or Other Jurisdiction of*          |   | *(I.R.S.  Employer Identification No.)* |
| *Incorporation  or Organization)*           |   | * *                                |
|                                        |   |                                    |
| **10  Forge Park, Franklin, Massachusetts** |   | **02038**                               |
| *(Address  of Principal Executive Offices)* |   | *(Zip  Code)*                           |

 

Registrant’stelephone number, including area code: **(508) 541-8800**

Indicate by checkmark whether the registrant: (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. **Yes **x**   No**o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.(Check one):

Large accelerated filer o                      Accelerated filer o                    Non-accelerated filer x

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act)  **Yes **o**   No**x

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.

 
| **Class**                  | ** ** | **Outstanding  at May 5, 2006** |
|----------------------------|------------|--------------------------------------|
| Common Stock, no par value |       | 30,084,078                           |

 

 

 

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**PLC SYSTEMS INC.**

**Index**

 
| Part I.  |   | Financial  Information: |   |                                                                                        |
|---------------|--------|-------------------------|--------|---------------------------------------------------------------------------------------------|
|          |   |                    |   |                                                                                        |   |   |
|          |   | Item 1.                 |   | Financial  Statements                                                                       |   |   |
|          |   |                    |   |                                                                                        |   |   |
|          |   |                    |   | Condensed Consolidated Balance Sheets (unaudited)                                           |   |   |
|          |   |                    |   |                                                                                        |   |   |
|          |   |                    |   | Condensed Consolidated Statements of Operations  (unaudited)                                |   |   |
|          |   |                    |   |                                                                                        |   |   |
|          |   |                    |   | Condensed Consolidated Statements of Cash Flows  (unaudited)                                |   |   |
|          |   |                    |   |                                                                                        |   |   |
|          |   |                    |   | Notes to Condensed Consolidated Financial Statements  (unaudited)                           |   |   |
|          |   |                    |   |                                                                                        |   |   |
|          |   | Item 2.                 |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |   |
|          |   |                    |   |                                                                                        |   |   |
|          |   | Item 3.                 |   | Quantitative  and Qualitative Disclosures about Market Risk                                 |   |   |
|          |   |                    |   |                                                                                        |   |   |
|          |   | Item 4.                 |   | Controls and  Procedures                                                                    |   |   |
|          |   |                    |   |                                                                                        |   |   |
|          |   |                    |   |                                                                                        |   |   |
| Part II. |   | Other Information:      |   |                                                                                        |
|          |   |                    |   |                                                                                        |   |   |
|          |   | Item  1A.               |   | Risk  Factors                                                                               |   |   |
|          |   |                    |   |                                                                                        |   |   |
|          |   | Item  6.                |   | Exhibits                                                                                    |   |   |

 

2

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**Part I.         FinancialInformation**

**Item1.**                          FinancialStatements

**PLCSYSTEMS INC.**CONDENSEDCONSOLIDATED BALANCE SHEETS(In thousands)(Unaudited)

 
| ** **                                                                                                                                                                     | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                     |       |                     |       |                        |       |
| Current assets:                                                                                                                                                                |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                                                                      |       | $                        | 5,033      |                        | $          | 2,560 |   |
| Short-term investments                                                                                                                                                         |       | 5,500                    |       | 6,900                       |       |
| Accounts receivable — Edwards                                                                                                                                             |       | 744                      |       | 634                         |       |
| Accounts receivable — other, net of allowance of $99  and $96 in 2006 and 2005, respectively                                                                         |       | 234                      |       | 153                         |       |
| Inventories, net                                                                                                                                                               |       | 996                      |       | 963                         |       |
| Prepaid expenses and other current assets                                                                                                                                      |       | 672                      |       | 798                         |       |
| Total current assets                                                                                                                                                           |       | 13,179                   |       | 12,008                      |       |
|                                                                                                                                                                           |       |                     |       |                        |       |
| Equipment,  furniture and leasehold improvements, net                                                                                                                          |       | 142                      |       | 235                         |       |
| Other assets                                                                                                                                                                   |       | 220                      |       | 224                         |       |
| Total assets                                                                                                                                                                   |       | $                        | 13,541     |                        | $          | 12,467 |   |
|                                                                                                                                                                           |       |                     |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                  |       |                     |       |                        |       |
| Current liabilities:                                                                                                                                                           |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                               |       | $                        | 439        |                        | $          | 352 |   |
| Accrued compensation                                                                                                                                                           |       | 493                      |       | 677                         |       |
| Accrued other                                                                                                                                                                  |       | 272                      |       | 334                         |       |
| Deferred revenue — Edwards                                                                                                                                                |       | 1,753                    |       | 1,621                       |       |
| Deferred revenue — other                                                                                                                                                  |       | 58                       |       | 60                          |       |
| Total current liabilities                                                                                                                                                      |       | 3,015                    |       | 3,044                       |       |
|                                                                                                                                                                           |       |                     |       |                        |       |
| Deferred revenue — Edwards                                                                                                                                                |       | 3,488                    |       | 3,692                       |       |
| Deferred revenue — other                                                                                                                                                  |       | 188                      |       | 188                         |       |
| Total long-term liabilities                                                                                                                                                    |       | 3,676                    |       | 3,880                       |       |
|                                                                                                                                                                           |       |                     |       |                        |       |
| Commitments and  contingencies                                                                                                                                                 |       |                     |       |                        |       |
|                                                                                                                                                                           |       |                     |       |                        |       |
| Stockholders’ equity:                                                                                                                                                     |       |                     |       |                        |       |
| Preferred stock, no par  value, unlimited shares authorized, none issued and outstanding                                                                                       |       | —                   |       | —                      |       |
| Common stock, no  par value, unlimited shares authorized, 30,084 and 30,080 shares issued and  outstanding as of March 31, 2006 and December 31, 2005,  respectively |       | 93,740                   |       | 93,737                      |       |
| Additional paid  in capital                                                                                                                                                    |       | 10                       |       | —                      |       |
| Accumulated  deficit                                                                                                                                                           |       | (86,559                  | )          | (87,850                     | )          |
| Accumulated  other comprehensive loss                                                                                                                                          |       | (341                     | )          | (344                        | )          |
| Total stockholders’ equity                                                                                                                                                |       | 6,850                    |       | 5,543                       |       |
| Total  liabilities and stockholders’ equity                                                                                                                               |       | $                        | 13,541     |                        | $          | 12,467 |   |

 

The accompanying notes are an integral part of the condensedconsolidated financial statements.

3

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**PLCSYSTEMS INC.**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share data)(Unaudited)

 
| ** **                                 | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Revenues:                                  |       |                                             |       |   |   |
| Product sales — Edwards               |       | $                                                | 1,176      |   | $ | 1,408 |   |
| Product sales — other                 |       | 304                                              |       | 150 |   |
| Service fees — Edwards                |       | 364                                              |       | 311 |   |
| Service fees — other                  |       | 45                                               |       | 74 |   |
| Total revenues                             |       | 1,889                                            |       | 1,943 |   |
|                                       |       |                                             |       |   |   |
| Cost of revenues:                          |       |                                             |       |   |   |
| Product sales — Edwards               |       | 363                                              |       | 485 |   |
| Product sales — other                 |       | 148                                              |       | 67 |   |
| Service fees — Edwards                |       | 142                                              |       | 138 |   |
| Service fees — other                  |       | 38                                               |       | 38 |   |
| Total cost of revenues                     |       | 691                                              |       | 728 |   |
|                                       |       |                                             |       |   |   |
| Gross profit                               |       | 1,198                                            |       | 1,215 |   |
|                                       |       |                                             |       |   |   |
| Operating expenses:                        |       |                                             |       |   |   |
| Selling, general and administrative        |       | 880                                              |       | 880 |   |
| Research and development                   |       | 533                                              |       | 571 |   |
| Total operating expenses                   |       | 1,413                                            |       | 1,451 |   |
| Gain on the sale  of manufacturing rights  |       | 1,432                                            |       | — |   |
|                                       |       |                                             |       |   |   |
| Income (loss)  from operations             |       | 1,217                                            |       | (236 | ) |
|                                       |       |                                             |       |   |   |
| Other income,  net                         |       | 74                                               |       | 52 |   |
|                                       |       |                                             |       |   |   |
| Net income  (loss)                         |       | $                                                | 1,291      |   | $ | (184 | ) |
|                                       |       |                                             |       |   |   |
| Basic and  diluted income (loss) per share |       | $                                                | 0.04       |   | $ | (0.01 | ) |
|                                       |       |                                             |       |   |   |
| Average shares  outstanding:               |       |                                             |       |   |   |
| Basic                                      |       | 30,080                                           |       | 30,068 |   |
| Diluted                                    |       | 30,592                                           |       | 30,068 |   |

 

The accompanying notes are an integral part of the condensedconsolidated financial statements.

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**PLCSYSTEMS INC.**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)(Unaudited)

 
| ** **                                                                                            | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                            | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Operating activities:                                                                                 |       |                                             |       |   |   |
| Net income (loss)                                                                                     |       | $                                                | 1,291      |   | $ | (184 | ) |
|                                                                                                  |       |                                             |       |   |   |
| Adjustments to  reconcile net income (loss) to net cash provided by (used for) operating  activities: |       |                                             |       |   |   |
| Depreciation and amortization                                                                         |       | 40                                               |       | 33 |   |
| Loss on retirement of equipment                                                                       |       | 69                                               |       | — |   |
| Compensation expense from stock options                                                               |       | 10                                               |       | — |   |
|                                                                                                  |       |                                             |       |   |   |
| Change in assets  and liabilities:                                                                    |       |                                             |       |   |   |
| Accounts receivable — Edwards                                                                    |       | (110                                             | )          | (89 | ) |
| Accounts receivable — other                                                                      |       | (81                                              | )          | 68 |   |
| Inventories                                                                                           |       | (33                                              | )          | (168 | ) |
| Prepaid expenses and other assets                                                                     |       | 125                                              |       | (185 | ) |
| Accounts payable                                                                                      |       | 87                                               |       | 74 |   |
| Deferred revenue — Edwards                                                                       |       | (72                                              | )          | 289 |   |
| Deferred revenue — other                                                                         |       | (2                                               | )          | (3 | ) |
| Accrued liabilities                                                                                   |       | (246                                             | )          | 39 |   |
| Net cash  provided by (used for) operating activities                                                 |       | 1,078                                            |       | (126 | ) |
|                                                                                                  |       |                                             |       |   |   |
| Investing activities:                                                                                 |       |                                             |       |   |   |
| Purchase of investments                                                                               |       | (4,000                                           | )          | (6,900 | ) |
| Maturity of investments                                                                               |       | 5,400                                            |       | — |   |
| Purchase of equipment                                                                                 |       | (12                                              | )          | (30 | ) |
| Net cash provided  by (used for) investing activities                                                 |       | 1,388                                            |       | (6,930 | ) |
|                                                                                                  |       |                                             |       |   |   |
| Financing activities:                                                                                 |       |                                             |       |   |   |
| Net proceeds from sales of common shares                                                              |       | 3                                                |       | — |   |
| Net cash provided  by financing activities                                                            |       | 3                                                |       | — |   |
|                                                                                                  |       |                                             |       |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                                         |       | 4                                                |       | (23 | ) |
| Net increase  (decrease) in cash and cash equivalents                                                 |       | 2,473                                            |       | (7,079 | ) |
|                                                                                                  |       |                                             |       |   |   |
| Cash and cash  equivalents at beginning of period                                                     |       | 2,560                                            |       | 9,678 |   |
| Cash and cash  equivalents at end of period                                                           |       | $                                                | 5,033      |   | $ | 2,599 |   |

 

The accompanying notes are an integral part of the condensedconsolidated financial statements.

 

5

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**PLC SYSTEMS INC.**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSMarch 31, 2006

***1.             Nature of Business***

PLCSystems Inc. (“PLC” or the “Company”) is a medical device company specializingin innovative technologies for the cardiac and vascular markets. The Companycurrently manufactures two lasers that are used in the treatment ofcardiovascular disease. PLC pioneered the *CO**2 Heart Laser System* (“The Heart LaserSystem”) that cardiac surgeons use to perform carbon dioxide (CO2) transmyocardial revascularization (“TMR”)to alleviate symptoms of severe angina. In addition, the Company manufacturesthe Optiwave 980 laser (“Optiwave 980”) under a supply agreement with EdwardsLifesciences LLC (“Edwards”). The Optiwave 980 is expected to be utilized bysurgeons to ablate cardiac tissue as a means to treat certain heartarrhythmias.

Edwardsis the Company’s exclusive distributor for TMR products in the United States. Edwardsis also the Company’s largest shareholder, owning approximately 18% of itsoutstanding common stock as of March 31, 2006.

***2.            ******Basis of Presentation***

The accompanying unauditedcondensed consolidated financial statements of the Company have been preparedin accordance with generally accepted accounting principles for interimfinancial information and with the instructions to Form 10-Q and Article 10of Regulation S-X. Accordingly, they do not include all of the information andfootnotes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring adjustments) considered necessary for a fair presentationhave been included. Operating results for the three months ended March 31,2006 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2006. These financial statements should be readin conjunction with the consolidated financial statements and footnotes theretoincluded in the Company’s Annual Report on Form 10-K for the yearended December 31, 2005.

***3.             EdwardsTransaction***

In February 2004, the Company signed an agreementwith Edwards to assume development and manufacturing of the Optiwave 980 andrelated system disposables. In March 2006, the Company and Edwardsterminated this agreement and entered into a new agreement. The Companyreceived $1,500,000 in consideration for selling its Optiwave 980 systemrelated disposable manufacturing anddevelopment rights to Edwards. The Company will continue to be the exclusivemanufacturer of the current generation of Optiwave 980 laser console forEdwards and will have certain rights of first refusal related to thedevelopment and manufacture of the next generation laser. Separately, Edwardswill pay the Company a royalty on all future Optiwave 980 system related disposablesales until such time that cumulative royalty payments from Edwards reach$1,700,000.

In conjunction with the sale of the Optiwave 980disposable manufacturing rights, the

6

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Company wrote offcertain inventory and capital assets acquired to manufacture the Optiwave 980disposables. The Company recorded a gain of $1,432,000 on the sale of itsmanufacturing rights in the accompanying statement of operations for the threemonths ended March 31, 2006. A summary of the components of this gain areas follows:

 

| Proceeds from sale of  manufacturing rights |   | $ 1,500,000 |   |
|---------------------------------------------|--------|------------------|--------|
| Net book value  of production equipment     |   | (52,000          | )      |
| Inventory                                   |   | (16,000          | )      |
| Gain on sale of  manufacturing rights       |   | $ 1,432,000 |   |

 

***4.             Earnings(Loss) per Share***

In2006, basic earnings per share have been computed using only the weightedaverage number of common shares outstanding during the period, while dilutedearnings per share have been computed using the weighted average number ofcommon shares outstanding during the period plus the effect of outstanding dilutivestock options using the treasury stock method.

Forthe three months ended 2005, basic and diluted loss per share have beencomputed using only the weighted average number of common shares outstandingduring the period without giving effect to any potential future issuances ofcommon stock related to stock option programs or warrants, since theirinclusion would be antidilutive.

In calculating diluted earnings per share, thedilutive effect of stock options is computed using the average market price forthe respective period. For the period ended March 31, 2006, 2,101,741shares attributable to outstanding stock options were excluded from thecalculation and for the period ended March 31, 2005, 5,168,422 sharesattributable to outstanding stock options and warrants were excluded from thecalculation of diluted earnings (loss) per share because the effect wasantidilutive. The following table sets forth the computation of basic anddiluted earnings (loss) per share.

|                                                                                                        | ** ** | **Three Months Ended  March 31,**                                                      | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2006**                                                                                              | ** ** | **2005** | ** ** |
| ** **                                                                                             | ** ** | **(In thousands, except per share data)**                                    | ** ** |
| Basic:                                                                                                 |       |                                                                                                  |       |   |   |
| Net income (loss)                                                                                      |       | $              1,291            |       | $               (184 | ) |
|                                                                                                   |       |                                                                                                  |       |   |   |
| Weighted average  shares outstanding                                                                   |       | 30,080                                                                                                |       | 30,068 |   |
|                                                                                                   |       |                                                                                                  |       |   |   |
| Earnings (loss)  per share                                                                             |       | $                0.04 |       | $              (0.01 | ) |
|                                                                                                   |       |                                                                                                  |       |   |   |
| Diluted:                                                                                               |       |                                                                                                  |       |   |   |
| Net income (loss)                                                                                      |       | $              1,291            |       | $               (184 | ) |
|                                                                                                   |       |                                                                                                  |       |   |   |
| Weighted average  shares outstanding                                                                   |       | 30,080                                                                                                |       | 30,068 |   |
|                                                                                                   |       |                                                                                                  |       |   |   |
| Assumed impact  of the exercise of outstanding dilutive stock options using the treasury stock  method |       | 512                                                                                                   |       | — |   |
|                                                                                                   |       |                                                                                                  |       |   |   |
| Weighted average  common and common equivalent shares                                                  |       | 30,592                                                                                                |       | 30,068 |   |
|                                                                                                   |       |                                                                                                  |       |   |   |
| Earnings (loss) per  share                                                                             |       | $                0.04 |       | $              (0.01 | ) |

 

7

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***5.             Stock-Based Compensation***

*StockOption and Stock Purchase Plans*

In May 2005, the Companyadopted the 2005 Stock Incentive Plan (the “2005 Plan”).  The 2005 Plan has replaced the 1997 ExecutiveStock Option Plan, 2000 Equity Incentive Plan, 2000 Non-Statutory Stock OptionPlan and 2000 Non-Qualified Performance and Retention Equity Plan (the“Previous Plans”), under which no further awards can be granted from thePrevious Plans after the adoption of the 2005 Plan.

The number of Options that may be granted under the2005 Plan is equal to 2,156,175 shares of common stock (subject to adjustmentin the event of stock splits and other similar events), plus such number ofshares as may become available under the Previous Plans after the date of theadoption of the 2005 Plan because any award previously granted under any suchplan expires or is terminated, surrendered or cancelled without having beenfully exercised or is forfeited in whole or in part or results in any commonstock not being issued, provided that such number of additional shares may notexceed 2,535,492.  Incentive stock optionsare issuable only to employees of the Company, while non-qualified options maybe issued to non-employee directors, consultants, and others, as well as toemployees. The options granted under the Previous Plans and the 2005 Planbecome exercisable either immediately, or ratably over one to four years fromthe date of grant, and expire ten years from the date of grant.  In March 2006, the Company granted newoptions to purchase 20,000 shares of the Company’s common stock to an employeewhich will vest ratably over a three year period.  In May 2005 and 2004, the Company granted newoptions to purchase 690,000 and 895,000 shares of the Company’s common stock,respectively, to employees and non-employee directors which vested immediatelyupon granting.

The Company grants stock options to its non-employeedirectors. Generally, new non-employee directors receive an initial grant of anoption to purchase 30,000 shares of the Company’s common stock that vests ininstallments over three years.  Once theinitial grant has fully vested, non-employee directors other than the Chairmanof the Board receive an annual grant of an option to purchase 15,000 shares ofthe Company’s common stock that generally vests either immediately or in fourequal quarterly installments. The Chairman of the Board receives an annualgrant of an option to purchase 30,000 shares of the Company’s common stock thatvests either immediately or in four equal quarterly installments in the samemanner as the options granted annually to the other non-employee directors. Allsuch options have an exercise price equal to the fair market value of thecommon stock on the date of grant.

The per share exercise price of the common stocksubject to an incentive stock option may not be less than the fair market valueof the common stock on the date the option is granted. The Company must grantnon-qualified options at an exercise price of at least 85% of the fair marketvalue of the common stock.

The Company has a 2000 Employee Stock Purchase Plan(the “Purchase Plan”) for all eligible employees.  Prior to December 1, 2005, shares of theCompany’s common stock could be purchased at six-month intervals at 85% of thelower of the fair market value on the first or the last day of each six-monthperiod.  On November 30, 2005, theCompany adopted an amendment to the Purchase Plan which provides that thepurchase price for each share of the Company’s common stock purchased under thePlan will be 95% of the closing price of the Company’s common stock on the lastbusiness day of the relevant plan period. The change in the purchase price was effective beginning with the planperiod commencing on December 1, 2005. Employees may purchase shares having avalue not exceeding 10% of their gross compensation during an offering period,subject to certain additional limitations. Under the Purchase Plan, employeesof the Company purchased 12,044 shares of common stock in 2005, and 13,390shares of common stock in 2004 at average prices of $0.50 and $0.70 per share,respectively.  There has been no purchaseactivity in the three months ended March 31, 2006.  At March 31, 2006, 322,487 shares werereserved for future issuance under the Purchase Plan.

*Adoption of SFAS 123(R)*

EffectiveJanuary 1, 2006, the Company adopted the fair value recognition provisionsof Statement of Financial Accounting Standards No. 123(R), *Share-Based Payment*(“SFAS 123R”)*,* using the modified-prospectivetransition method which did not require restatement of prior period results.Under this transition method, compensation expense totaling $10,000 wasrecognized in the accompanying statement of operations for the three monthsended March 31, 2006. The compensation expense recorded includes(a) $9,000 of compensation cost for all share-based payments granted priorto, but not yet vested as of January 1, 2006, based on the grant date fairvalue calculated in accordance with the original provisions of Statement ofFinancial Accounting Standards No. 123, *Accountingfor Stock-based Compensation* (“SFAS 123”), and (b) $1,000of compensation cost for all share-based payments granted subsequent toDecember 31, 2005, based on the grant-date fair value estimated inaccordance with the provisions of SFAS 123R. As of March 31, 2006, theCompany had $23,000 of total unrecognized compensation cost related to its unvestedoptions, which is expected to be recognized over a weighted average period offive months.

The weightedaverage fair value of options issued during the three months endedMarch 31, 2006 were estimated using the Black-Scholes model. The value ofthese options using the assumptions noted in the following table amounted to$0.49 per share.

|                          | ** ** | **Three Months Ended  March 31, 2006** | ** ** |
|--------------------------|------------|------------------------------------------------------------|------------|
| Expected life  (years)   |       | 6                                                          |       |
| Risk-free  interest rate |       | 4.07                                                       | %          |
| Expected  volatility     |       | 93.30                                                      | %          |
| Expected dividend yield  |       | None                                                       |       |

 

The expected lifeis calculated using the simplified method. The risk-free interest rate is basedon the U.S. Treasury yield curve in effect at the time of the grant for theexpected term period. Expected volatility is based exclusively on historicalvolatility data of the Company’s common stock.

*OptionsOutstanding*

The followingtable summarizes stock option activity during the three months ended March 31,2006:

8

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| ** **                           | ** ** | **Number of  Options**                                         | ** ** | **Weighted  Average  Exercise  Price**                                  | ** ** | **Weighted  Average  Remaining  Contractual  Term (Years)** | ** ** | **Aggregate  Intrinsic  Value**                                              | ** ** |
|--------------------------------------|------------|---------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **(in thousands, except per option data)** | ** ** |
| Outstanding,  December 31, 2005 |       | 4,688                                                               |       | $           1.19 |       |                                                             |       |                                                                         |       |
| Granted                              |       | 20                                                                  |       | 0.63                                                                    |       |                                                             |       |                                                                         |       |
| Exercised                            |       | (4                                                                  | )          | 0.55                                                                    |       |                                                             |       |                                                                         |       |
| Canceled                             |       | (7                                                                  | )          | 1.42                                                                    |       |                                                             |       |                                                                         |       |
| Outstanding,  March 31, 2006    |       | 4,697                                                               |       | 1.18                                                                    |       | 6.46                                                             |       | $            568 |       |
| Exercisable,  March 31, 2006    |       | 4,583                                                               |       | 1.20                                                                    |       | 6.42                                                             |       | $            562 |       |

 

The aggregate intrinsic value amounts in the tableabove represent the difference between the closing price of the Company’scommon stock on March 31, 2006 and the exercise price, multiplied by thein-the-money stock options as of the same date. The total intrinsic value ofoptions exercised during the three months ended March 31, 2006 was lessthan $1,000.

The followingtable summarizes unvested share activity during the three months ended March31, 2006:
| ** **                    | ** ** | **Number  of Options**                                               | ** ** | **Weighted Average  Grant Date  Fair Value**                                                       | ** ** |
|-------------------------------|------------|---------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|
| ** **                    | ** ** | **(in thousands, except weighted average data)** | ** ** |
| Nonvested,  December 31, 2005 |       | 101                                                                       |       | $                  0.37 |       |
| Granted                       |       | 20                                                                        |       | 0.49                                                                                                              |       |
| Vested                        |       | —                                                                    |       | —                                                                                                            |       |
| Canceled                      |       | (7                                                                        | )          | 0.74                                                                                                              |       |
| Nonvested, March 31,  2006    |       | 114                                                                       |       | $                  0.37 |       |

 

*Pro FormaInformation for Period Prior to SFAS 123(R) Adoption*

The Company has historically granted stock options fora fixed number of shares to employees and certain other individuals withexercise prices equal to the fair value of the shares at the dates of grant.Through December 31, 2005 the Company adopted the disclosure onlyprovisions of SFAS 123, and accounted for its stock option plans in accordancewith the provisions of Accounting Principles Board Opinion 25, *Accounting for Stock Issued to Employees*(“APB Opinion No. 25”).Under APB Opinion No. 25, compensation expense with respect to such awardsis not recognized if on the date the awards were granted the exercise price wasequal to or greater than the fair market value of the underlying common shares.

The following table illustrates the effect on net lossand basic loss per share if the Company had applied the fair value recognitionprovisions of SFAS 123 to stock-based employee compensation during the threemonth period ended March 31, 2005. For purposes of this pro formadisclosure, the value of the options is estimated using the Black-Scholesoption-pricing model and is being amortized to expense over the options’vesting periods.

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| ** **                                                                                                           | ** ** | **Three Months Ended  March 31, 2005**                                                                                | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **(In thousands, except  per share data)**                                                                            | ** ** |
| Net loss  attributable to common stockholders—As reported                                                       |       | $                      (184 | )          |
| Deduct total  stock-based compensation expense determined under fair value based method for  all stock option awards |       | (34                                                                                                                                       | )          |
| Net loss  attributable to common stockholders—Pro forma                                                         |       | $                      (218 | )          |
| Loss per basic  and diluted share attributable to common stockholders—As reported                               |       | $                     (0.01      | )          |
| Loss per basic and  diluted share attributable to common stockholders—Pro forma                                 |       | $                     (0.01      | )          |

 

The Company did not grant anystock options during the quarter ended March 31, 2005. Therefore, therewere no assumptions of expected life, interest rate, volatility or expected dividend yield withrespect to the Black-Scholes model for such period.

***6.             ComprehensiveIncome (Loss)***

Total comprehensive income for the three-month periodended March 31, 2006 amounted to $1,294,000 as compared to a comprehensiveloss of $198,000 for the three month period ended March 31, 2005. Comprehensiveincome (loss) is comprised of net income (loss) plus the increase/decrease incurrency translation adjustment.

***7.             Inventories***

Inventories are stated at the lower of cost (computedon a first-in, first-out method) or market value and include allocations oflabor and overhead. As of March 31, 2006 and 2005 inventories consisted ofthe following (in thousands):

 

|                  | ** ** | **March 31,  2006**                                               | ** ** | **December 31,  2005**                                            | ** ** |
|------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| Raw materials    |       | $           800 |       | $           701 |       |
| Work in progress |       | 76                                                                     |       | 67                                                                     |       |
| Finished goods   |       | 120                                                                    |       | 195                                                                    |       |
|             |       | $           996 |       | $           963 |       |

 

At March 31, 2006 and December 31, 2005,inventories are stated net of a reserve of $479,000 and $533,000, respectively,for potentially excess and obsolete inventory.

***8.             Revenue Recognition***

The Company records revenue from the sale of TMR kitsand the Optiwave 980 at the 

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time of shipmentto Edwards. TMR kit revenues include the amount invoiced to Edwards for kits shippedpursuant to purchase orders received, as well as an amortized portion ofdeferred revenue related to a payment of $4,533,333 received from Edwards in February 2004.This payment was made by Edwards in exchange for a reduction in the prospectivepurchase price the Company receives from Edwards upon a sale of the kits (seeNote 3). The Company is amortizing this payment from Edwards into itsConsolidated Statement of Operations as revenue over a seven year period(culminating in 2010) under the units-of-revenue method as prescribed byEmerging Issues Task Force (EITF) 88-18, *Sales ofFuture Revenue*. Management determined that a seven year timeframewas the most appropriate amortization period based on a valuation model theyused to assess the economic fairness of the payment. Factors managementconsidered in developing this valuation model included the estimated foregonerevenues over a seven year period resulting from the reduction in theprospective purchase price payable to the Company by Edwards, a discount ratedeemed appropriate to this transaction and an estimate of the remainingeconomic useful life of the current TMR kit design, without any benefit beinggiven to potential future product improvements the Company may make. Managementreviews annually, and adjusts if necessary, the prospective revenueamortization rate for kits based on its best estimate of the total number ofkits likely remaining to be shipped to hospital customers by Edwards through2010. Based on this, for the three months ended March 31, 2006 and 2005the Company recorded amortization of $155,000 and $76,000, respectively, whichis included in revenues in the Consolidated Statements of Operations.

TMR lasers are billed to Edwards in accordance withpurchase orders that the Company receives. Invoiced TMR lasers are recorded asother current assets and deferred revenue on the Company’s Consolidated BalanceSheet until such time as the laser is shipped to a hospital, at which time theCompany records revenue and cost of revenue.

Under the terms of the Edwards TMR distributionagreement, once Edwards has recovered a prescribed amount of revenue from ahospital for the use or purchase of a TMR laser, any additional revenues earnedby Edwards are shared with the Company pursuant to a formula established in thedistribution agreement. The Company only records its share of such additionalrevenue, if any, at the time the revenue is earned.

The Company records revenuefrom the sale of TMR kits and TMR lasers to international distributors orhospitals at the time of shipment.

Revenues from service andmaintenance contracts are recognized ratably over the life of the contract.

Installation revenuesrelated to a TMR laser transaction are recorded as a component of service feeswhen the laser is installed.

# ***9.             Warranty andPreventative Maintenance Costs***

TheCompany warranties its products against manufacturing defects under normal useand service during the warranty period. The Company obtains similar warrantiesfrom a majority of its suppliers, including those who supply critical HeartLaser System components. In addition, under the terms of its TMR distributionagreement with Edwards, the Company is able to bill Edwards for actual warrantycosts, including preventative maintenance services, up to a specified amountduring the warranty period.

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TheCompany evaluates the estimated future unrecoverable costs of warranty andpreventative maintenance services for its installed base of lasers on aquarterly basis and adjusts its warranty reserve accordingly. The Companyconsiders all available evidence, including historical experience andinformation obtained from supplier audits.

Changes in the warranty accrual were as follows (inthousands):

 

|                                                            | ** ** | **Three Months Ended  March 31,**                                              | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                                                                      | ** ** | **2005** | ** ** |
| Balance,  beginning of period                              |       | $               60 |       | $               60 |   |
| Payments made                                              |       | —                                                                                        |       | — |   |
| Change in  liability for warranties issued during the year |       | 5                                                                                             |       | — |   |
| Change in  liability for preexisting warranties            |       | (5                                                                                            | )          | — |   |
| Balance, end of period                                     |       | $               60 |       | $               60 |   |

 

**Item 2.        Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

This quarterly report (including certain informationincorporated herein by reference) contains forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended (the “Exchange Act”).Statements containing terms such as “believes”, “plans”, “expects”, “anticipates”,“intends”, “estimates” and similar expressions reflect uncertainty and areforward-looking statements. Forward-looking statements are based on currentplans and expectations and involve known and unknown important risks anduncertainties that could cause actual results to differ materially from thosedescribed in the forward-looking statements. Such important factors anduncertainties include, but are not limited to, those set forth below in Part II,Item 1A. Risk Factors, and elsewhere in this quarterly report.

# **Overview**

We are a medical device company specializing ininnovative technologies for the cardiac and vascular markets. We currentlymanufacture two lasers that are used in the treatment of cardiovascular disease.Our Heart Laser Systems are used to treat patients with severe angina and theOptiwave 980 is used to ablate cardiac tissue as a means to treat certain heartarrhythmias.

Edwards is our exclusive distributor for TMR productsin the United States and our largest customer, accounting for approximately 82%and 89% of our total sales in the three month period ended March 31, 2006and for the year ended December 31, 2005, respectively. We expect thissales trend to continue for the near future.

Approximately 97% and 89% of our revenues in the threemonths ended March 31, 2006 and the year ended December 31, 2005 camefrom the sale and service of TMR lasers and related disposable kits. Althoughnot a direct measure, we believe a leading indicator of the adoption rate ofTMR as a treatment for severe angina is TMR kit shipments to U.S. hospitals. TMRkit 

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shipmentsto U.S. hospitals through Edwards increased approximately 12% in the threemonth period ended March 31, 2006 compared to the three month period endedMarch 31, 2005. We remain largely dependent on the success of Edwards’sales and marketing efforts to increase our installed base of TMR lasers andincrease TMR procedure volumes and revenues.

Our management reviews a number of key performanceindicators to assist them in determining how to allocate resources and run ourday to day operations. These indicators include (1) actual prior quarterlysales trends, (2) projected TMR laser and kit sales for the next fourquarters, as provided by Edwards in a rolling twelve month sales forecast, (3) researchand development progress as measured against internal project plan objectives, (4) budgetto actual financial expenditure results, (5) inventory levels (both ourown and Edwards’) and (6) short term and long term projected cash flows ofthe business.

# **CriticalAccounting Policies and Estimates**

Our financial statements are based on the application of significantaccounting policies, many of which require us to make significant estimates andassumptions (see Note 2 to the Consolidated Financial Statements). We believethat the following are some of the more material judgment areas in theapplication of our accounting policies that currently affect our financialcondition and results of operations.

# ***Inventories***

Inventories are stated at the lower of cost (computedon a first-in, first-out method) or market value and include allocations oflabor and overhead. A specific obsolescence allowance is provided for slowmoving, excess and obsolete inventory based on our best estimate of the netrealizable value of inventory on hand taking into consideration factors such as(1) actual trailing twelve month sales, (2) expected future productline demand, based in part on sales forecast input received from Edwards, and (3) servicepart stocking levels which, in management’s best judgment, are advisable tomaintain in order to meet warranty, service contract and time and materialspare part demands. Historically, we have found our reserves to be adequate.

# ***Allowance for Doubtful Accounts***

For our accounts receivable, we continuously monitorcollections from customers, our principal customer being Edwards, and wemaintain a provision for estimated credit losses based upon historicalexperience and any specific customer collection issues that we have identified.Historically, we have not experienced significant losses related to ouraccounts receivable. Collateral is not generally required. If the financialcondition of our customers were to deteriorate, resulting in an impairment oftheir ability to make payments, additional allowances may be required.

# ***Warranty and Preventative Maintenance Costs***

We warranty our products against manufacturing defectsunder normal use and service during the warranty period. We obtain similarwarranties from a majority of our suppliers, including those who supplycritical Heart Laser System components. In addition, under the terms of our TMRdistribution agreement with Edwards, we are able to bill Edwards for actualwarranty costs, including preventative maintenance services, up to a specifiedamount during the 

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warranty period.

We evaluate the estimated future unrecoverable costsof warranty and preventative maintenance services for our installed base oflasers on a quarterly basis and adjust our warranty reserve accordingly. Weconsider all available evidence, including historical experience andinformation obtained from supplier audits.

## ***Revenue Recognition***

We record revenue from the sale of TMR kits and theOptiwave 980 at the time of shipment to Edwards. TMR kit revenues include theamount invoiced to Edwards for kits shipped pursuant to purchase ordersreceived, as well as an amortized portion of deferred revenue related toEdwards’ payment to us of $4,533,333 in February 2004. This payment wasmade by Edwards in exchange for a reduction in the prospective purchase pricewe receive from Edwards upon a sale of the kits. We are amortizing this paymentfrom Edwards into our Consolidated Statement of Operations as revenue over aseven year period (culminating in 2010) under the units-of-revenue method asprescribed by Emerging Issues Task Force (EITF) 88-18, *Sales of Future Revenue*. We determined that a seven yeartimeframe was the most appropriate amortization period based on a valuationmodel we used to assess the economic fairness of the payment. Factors weconsidered in developing this valuation model included the estimated foregonerevenues over a seven year period resulting from the reduction in theprospective purchase price payable to us by Edwards, a discount rate deemedappropriate to this transaction and an estimate of the remaining economicuseful life of the current TMR kit design, without any benefit being given topotential future product improvements we may make. Management reviews annually,and adjusts if necessary, the prospective revenue amortization rate for kitsbased on its best estimate of the total number of kits likely remaining to beshipped to hospital customers by Edwards through 2010. Based on this, for thethree months ended March 31, 2006 and 2005 we recorded amortization of$155,000 and $76,000, respectively, which is included in revenues in ourConsolidated Statements of Operations.

TMRlasers are billed to Edwards in accordance with purchase orders that we receive.Invoiced TMR lasers are recorded as other current assets and deferred revenueon our Consolidated Balance Sheet until such time as the laser is shipped to ahospital, at which time we record revenue and cost of revenue.

Underthe terms of the Edwards TMR distribution agreement, once Edwards has recovereda prescribed amount of revenue from a hospital for the use or purchase of a TMRlaser, any additional revenues earned by Edwards are shared with us pursuant toa formula established in the distribution agreement. We only record our shareof such additional revenue, if any, at the time the revenue is earned.

We record revenue from thesale of TMR kits and TMR lasers to international distributors or hospitals atthe time of shipment.

Revenues from service and maintenance contracts are recognized ratably over thelife of the contract.

Installation revenues relatedto a TMR laser transaction are recorded as a component of service fees when thelaser is installed.

 

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**Stock Based Compensation**

Effective January 1, 2006, we adopted the fairvalue recognition provisions of SFAS 123R*,*using the modified-prospective transition method which did not requirerestatement of prior period results. Under this transition method, compensationexpense totaling $10,000 was recognized in our statement of operations for thethree months ended March 31, 2006. The compensation expense recordedincludes (a) $9,000 of compensation cost for all share-based paymentsgranted prior to, but not yet vested as of January 1, 2006, based on thegrant date fair value calculated in accordance with the original provisionsSFAS 123, and (b) $1,000 of compensation cost for all share-based paymentsgranted subsequent to December 31, 2005, based on the grant-date fairvalue estimated in accordance with the provisions of SFAS 123(R). As of March 31,2006, we had $23,000 of total unrecognized compensation cost related to ourunvested options, which is expected to be recognized over a weighted averageperiod of five months.

The valuation of employee stock options is aninherently subjective process, since market values are generally not availablefor long-term, non-transferable employee stock options. Accordingly, an optionpricing model is utilized to derive an estimated fair value. In calculating theestimated fair value of our stock options, we used the Black-Scholes pricingmodel which requires the consideration of six variables for purposes ofestimating fair value which include the stock option exercise price, the grantdate price of our common stock, the expected life of the option, the risk freeinterest rate for the expected option life, the expected volatility of ourcommon stock, the expected dividends on our common stock. The expected life iscalculated using the simplified method. The risk-free interest rate is based onthe U.S. Treasury yield curve in effect at the time of the grant for theexpected term period. Expected volatility is based exclusively on historicalvolatility data on our common stock. The dividend yield percentage is zerobecause we do not currently pay dividends nor intend to do so during theexpected option life.

## **Results of Operations**

Results for the threemonths ended March 31, 2006 and 2005 and the related percent of revenueswere as follows:

 

 
| ** **                                  | ** ** | **Three Months Ended   March 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                               | ** ** | **2005** | ** ** |
| ** **                                  | ** ** | **$**                                                  | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                  | ** ** | **(dollars in thousands)**                   | ** ** |
| Total revenues                              |       | $                                                      | 1,889      |   | 100 | % | $ | 1,943 |   | 100 | % |
| Total cost of  revenues                     |       | 691                                                    |       | 37 |   | 728 |   | 37 |   |
| Gross profit                                |       | 1,198                                                  |       | 63 |   | 1,215 |   | 63 |   |
| Selling,  general & administrative |       | 880                                                    |       | 47 |   | 880 |   | 45 |   |
| Research &  development expenses   |       | 533                                                    |       | 28 |   | 571 |   | 29 |   |
| Total operating  expenses                   |       | 1,413                                                  |       | 75 |   | 1,451 |   | 75 |   |
| Gain on sale of  manufacturing rights       |       | 1,432                                                  |       | 76 |   | — |   | — |   |
| Income (loss)  from operations              |       | 1,217                                                  |       | 64 |   | (236 | ) | (12 | ) |
| Other income                                |       | 74                                                     |       | 4 |   | 52 |   | 3 |   |
| Net income (loss)                           |       | $                                                      | 1,291      |   | 68 | % | $ | (184 | ) | (9 | )% |

 

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| ** **                                           | ** ** | **Three Months Ended  March 31,** | ** ** | ** ** | ** ** | ** **                                   | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|----------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                         | ** ** | **2005**   | ** ** | **Increase (decrease)  over 2005** | ** ** |
| ** **                                           | ** ** | **$**                                            | ** ** | **$**      | ** ** | **$**                                        | ** ** | **%** | ** ** |
| ** **                                           | ** ** | **(dollars in thousands)**             | ** ** |
| Product sales                                        |       | $                                                | 1,480      |       | $          | 1,558                                        |       | $ | (78 | ) | (5 | )% |
| Service fees                                         |       | 409                                              |       | 385        |       | 24                                           |       | 6 |   |
| Total revenues                                       |       | 1,889                                            |       | 1,943      |       | (54                                          | )          | (3 | ) |
| Product cost of  sales                               |       | 511                                              |       | 552        |       | (41                                          | )          | (7 | ) |
| Service fees  cost of sales                          |       | 180                                              |       | 176        |       | 4                                            |       | 2 |   |
| Total cost of  revenues                              |       | 691                                              |       | 728        |       | (37                                          | )          | (5 | ) |
| Gross profit                                         |       | 1,198                                            |       | 1,215      |       | (17                                          | )          | (1 | ) |
| Selling,  general & administrative expenses |       | 880                                              |       | 880        |       | —                                       |       | — |   |
| Research &  development expenses            |       | 533                                              |       | 571        |       | (38                                          | )          | (7 | ) |
| Total operating  expenses                            |       | 1,413                                            |       | 1,451      |       | (38                                          | )          | (3 | ) |
| Gain on sale of  manufacturing rights                |       | 1,432                                            |       | —     |       | 1,432                                        |       | 100 |   |
| Income (loss)  from operations                       |       | 1,217                                            |       | (236       | )          | 1,453                                        |       | 616 |   |
| Other income                                         |       | 74                                               |       | 52         |       | 22                                           |       | 42 |   |
| Net income (loss)                                    |       | $                                                | 1,291      |       | $          | (184                                         | )          | $ | 1,475 |   | 802 |   |

 

***Product Sales***

TMRlaser revenues, the largest component of product sales in the three monthsended March 31, 2006, increased by $75,000, or 11%, as compared to thethree months ended March 31, 2005. International TMR laser revenuesincreased $205,000, from $15,000 to $220,000, due to the sale of a single laserto an international customer in the three months ended March 31, 2006. DomesticTMR laser revenues decreased $130,000, or 19%, as a result of (1) adecrease in the number of new TMR lasers sold by Edwards and (2) a loweraverage selling price on domestic TMR laser sales, offset in part by (3) increasedrevenue sharing earned under the TMR distribution agreement with Edwards.

DisposableTMR kit revenues, the second largest component of product sales, increased by$30,000, or 5%, in the three months ended March 31, 2006 as compared to thethree months ended March 31, 2005. Domestic disposable TMR kit revenuesincreased by $81,000, or 15%, primarily due to a $79,000 increase in deferredrevenue amortization related to the $4,533,333 payment by Edwards. Internationaldisposable TMR kit revenues decreased $51,000, or 65%, as a result of a lowervolume of kit shipments to international customers.

Optiwave980 revenues to Edwards decreased $153,000, or 100%, in the three months ended March 31,2006 as compared to the three months ended March 31, 2005, as noOptiwave 980 units were sold to Edwards in the first quarter of 2006. Under ournew supply agreement with Edwards that we entered into in March 2006,Edwards has agreed to purchase any additional units of the current generationof Optiwave 980 exclusively from us. We believe that our future revenues fromsales of this first generation laser will not exceed $1,000,000 and may beless, depending in part on demand for that product and when, if ever, Edwardschooses to introduce its next generation laser to the market. We have a rightof first refusal to develop and manufacture 

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the nextgeneration laser for Edwards; however, at this time we have not had discussionswith Edwards regarding any such successor product.

Otherproduct sales, relating to sales of new and refurbished surgical tubes, decreased$30,000, or 32%, in the three months ended March 31, 2006 as compared tothe three months ended March 31, 2005.

***Service Fee Revenues***

Service fees increased $24,000, or 6%, in the threemonths ended March 31, 2006 as compared to the three months ended March 31,2005. Domestic service fees increased $52,000, or 17%, primarily due toincreased revenue generated from service contracts. International service feesdecreased $28,000, or 38%, due to a decreased number of billings tointernational customers.

***Gross Profit***

Totalgross profit was $1,198,000, or 63% of total revenues, for the three monthsended March 31, 2006 as compared with gross profit of $1,215,000, or 63%of total revenues, for the three months ended March 31, 2005. The decreasein gross profit dollars is due to (1) lower Optiwave 980 revenues (2) adecrease in the number of new domestic TMR lasers sold and (3) a loweraverage domestic selling price on TMR laser sales. These decreases were offsetin part by (1) higher international TMR laser sales, (2) an increasein additional revenue sharing earned under the TMR distribution agreement withEdwards and (3) higher disposable TMR revenues.

***Selling,******Generaland Administrative Expenses***

Theoverall level of expenditures remained unchanged in the three months ended March 31,2006 as compared to the three months ended March 31, 2005. Legal expensesand other related corporate expenditures increased during the first quarter of2006, while salary and related fringe benefits decreased by similar offsettingamounts.

***Research******and Development Expenses***

Researchand development expenditures decreased 7% in the three months ended March 31,2006 as compared to the three months ended March 31, 2005. There was adecrease in Optiwave 980 System expenditures, offset in part by increasedexpenditures in connection with product development and clinical work on anadditional internal research and development initiative.

Weexpect to continue to incur significant new research and developmentexpenditures in 2006 and future years in pursuit of our business strategy tobroaden and diversify our product portfolio beyond our current TMR offerings.

***Gain on Sale of Manufacturing******Rights***

In March 2006,we received $1,500,000 related to the sale of our Optiwave 980 System disposablemanufacturing and development rights to Edwards (See Note 3 to the consolidatedfinancial statements). In conjunction with this transaction, we wrote-offcertain inventory and capital assets acquired to manufacture the Optiwave 980disposables, and we

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recorded a gain of$1,432,000 on the sale of our manufacturing rights for the three months ended March 31,2006. A summary of the components of this gain are outlined below:

 

| Proceeds from sale of  manufacturing rights |   | $       | 1,500,000 |   |
|---------------------------------------------|--------|---------|-----------|--------|
| Net book value  of production equipment     |   | (52,000 | )         |
| Inventory                                   |   | (16,000 | )         |
| Gain on sale of  manufacturing rights       |   | $       | 1,432,000 |   |

 

***Other Income***

Thelargest component of other income is interest income earned on our cash, cashequivalents and short-term investments. Interest income increased $22,000, or42%, in the three months ended March 31, 2006 as compared to the threemonths ended March 31, 2005 due to higher cash balances coupled withhigher interest rates earned on our cash, cash equivalents and short-terminvestments.

***Net Income (Loss)***

In the three months endedMarch 31, 2006, we recorded a gain of $1,432,000 from the sale of ourOptiwave 980 disposable manufacturing rights to Edwards. This non-recurringgain resulted in our recording net income of $1,291,000 for the three monthsended March 31, 2006, as compared to a net loss of $184,000 for the threemonths ended March 31, 2005.

***Kit Shipments***

Weview disposable kit shipments to end users as an important metric in evaluatingour business. We believe that kit shipments (particularly kit shipments to U.S.hospitals), although not a direct measure, are a reasonable indicator for theadoption of TMR as a therapy in the marketplace. Disposable kit shipments toend users are as follows:

 

|                        | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------|------------|--------------------------------------------------|------------|
| ** **             | ** ** | **2006**                                         | ** ** | **%  Increase  (Decrease)  Over  2005** | ** ** | **2005** | ** ** |
| Domestic (by  Edwards) |       | 491                                              |       | 12 | % | 439 |   |
| International          |       | 15                                               |       | (70 | ) | 50 |   |
| Total                  |       | 506                                              |       | 3 | % | 489 |   |

 

We believe the 12%growth in domestic kit shipments in the three months ended March 31, 2006over the three months ended March 31, 2005 was primarily due to anincreased base of installed TMR lasers available to perform TMR procedures anda continued focus on driving TMR procedural volume by the Edwards disposable TMRsales team.

The overall limited growth in TMR kit shipments inrecent years may be partly attributable to what we believe may be an ongoingdownward trend in the number of bypass surgeries being performed. We believethe proliferation in the number of interventional cardiac procedures being 

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performed, particularly with the recent advent of drug eluting stents,is causing a delay in the number of patients being referred to cardiac surgeonsfor treatment of their cardiovascular disease. Because a significantnumber of the total TMR procedures performed each year by cardiac surgeons aredone in combination with bypass surgery, we believe the growth in the number ofTMR procedures may be being adversely impacted by this reduction in the numberof bypass surgeries being performed.

**Liquidityand Capital Resources**

Cash,cash equivalents and short-term investments totaled $10,533,000 as of March 31,2006, an increase of $1,073,000 from $9,460,000 as of December 31, 2005. Ourshort-term investments consist of monies invested in bank certificates ofdeposit. We have no debt obligations. We believe that our existing cashresources will meet our working capital requirements through at least the next12 months.

Cashprovided by operating activities in the three months ended March 31, 2006was $1,078,000 due to our net income and non-cash depreciation, amortization,loss on retirement of equipment and compensation expense related to stockoptions, partially offset by overall unfavorable working capital changes. Additionalcash was provided by net proceeds from the sales of common shares of $3,000 andthe effect of foreign exchange rate changes totaling $4,000. We used $12,000related to the purchase of equipment.

Weare largely dependent on the success of Edwards’ sales and marketing efforts inthe U.S. to continue to increase the installed base of HL2 and Optiwave 980lasers and to substantially increase TMR procedural volumes and revenues.Should the installed base of HL2 lasers or TMR procedural volume not increasesufficiently, our liquidity and capital resources will be negatively impacted. Additionally,other unanticipated decreases in operating revenues or increases in expenses orchanges or delays in third-party reimbursement to healthcare providers usingour products may adversely impact our cash position and require further costreductions or the need to obtain additional financing. It is not certain thatwe, working with Edwards and our international distributors, will be successfulin achieving broad commercial acceptance of either the Heart Laser Systems orthe Optiwave 980, or that we will be able to operate profitably in the futureon a consistent basis, if at all.

Some hospital customers prefer to acquire the HeartLaser Systems on a usage basis rather than as a capital equipment purchase. Webelieve this is the result of limitations many hospitals currently have onacquiring expensive capital equipment as well as competitive pressures in themarketplace. A usage business model will result in a longer recovery period forEdwards to recoup its investment in lasers it purchases from us. This resultsin (1) a delay in our ability to receive additional shared revenue, ifany, that we otherwise are entitled to receive under the terms of ourdistribution agreement with Edwards (see “Critical Accounting Policies andEstimates — Revenue Recognition”) and (2) a delay in the purchase of newlasers by Edwards if its installed base of lasers placed under usage contractsare under-performing and it chooses to re-deploy these lasers to other hospitalsites in lieu of purchasing a new laser from us. Our cash position and our needfor additional financing to fund operations will be dependent in part upon thenumber of hospitals that acquire Heart Laser Systems from Edwards on a usagebasis and the number and frequency of TMR procedures performed by thesehospitals.

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Furthermore, we have undertaken a new businessstrategy that involves broadening and diversifying our product portfolio beyondour current TMR offerings, by developing or acquiring new and innovativemedical devices to address cardiac and vascular related markets. We believe this strategy will result in our incurringlosses for at least the next 12-24 months as we increase our spending inthe area of research and development. We cannot be certain that we will besuccessful in implementing our business strategy or that future sales, if any,from these planned new products will recover the investments we plan to make.If we are unsuccessful in implementing our business strategy, or if thediversification of our product portfolio takes longer or costs more thananticipated, our liquidity and capital resources will be adversely affected andwe may need to obtain additional financing.

Therecan be no assurance that, should we require additional financing, suchfinancing will be available on terms and conditions acceptable to us, if at all.Should additional financing not be available on terms and conditions acceptableto us, additional actions may be required that could adversely impact ourability to continue to realize assets and satisfy liabilities in the normalcourse of business. The consolidated financial statements set forth in thisreport do not include any adjustments to reflect the possible future effects ofthese uncertainties.

**Off-BalanceSheet Arrangements**

None.

**Item 3.**                          Quantitativeand Qualitative Disclosures about Market Risk

A portion of our operations consists of sales activities in foreign jurisdictions.We manufacture our products exclusively in the U.S. and sell our products inthe U.S. and abroad. As a result, our financial results could be affected byfactors such as changes in foreign currency exchange rates or weak economicconditions in the foreign markets in which we distribute our products. Ouroperating results are exposed to changes in exchange rates between the U.S.dollar and foreign currencies, especially the Euro. When the U.S. dollarstrengthens against the Euro, the value of foreign sales decreases. When theU.S. dollar weakens, the value of foreign sales increases. No assurance can begiven that foreign currency fluctuations in the future will not adverselyaffect our business, financial condition and results of operations, although atpresent we do not believe that our exposure is significant, as internationalsales represented only 16% and 6%, respectively, of our consolidated sales inthe three months ended March 31, 2006 and the year ended December 31,2005. We do not hedge any balance sheet exposures and intercompany balancesagainst future movements in foreign exchange rates.

Ourinterest income and expense are sensitive to changes in the general level ofU.S. and foreign interest rates. In this regard, changes in U.S. and foreigninterest rates affect the interest earned on our cash and cash equivalents. Wedo not believe that a 10% change to the applicable interest rates would have amaterial impact on our future results of operations or cash flows.

**Item 4.**                          Controlsand Procedures

Our management, with theparticipation of our chief executive officer and chief financial officer,evaluated the effectiveness of our disclosure controls and procedures as of March 31,2006. The term “disclosure controls and procedures”, as defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act, means controls and otherprocedures of a company that are 

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designed to ensurethat information required to be disclosed by a company in the reports that itfiles or submits under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms. Disclosurecontrols and procedures include, without limitation, controls and proceduresdesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is accumulated andcommunicated to the company’s management, including its principal executive andprincipal financial officers, as appropriate to allow timely decisions regardingrequired disclosure. Management recognizes that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving their objectives and management necessarily applies its judgment inevaluating the cost-benefit relationship of possible controls and procedures. Basedon the evaluation of our disclosure controls and procedures as of March 31,2006, our chief executive officer and chief financial officer concluded that,as of such date, our disclosure controls and procedures were effective at thereasonable assurance level.

No change in our internal control over financial reporting (as definedin Rules 13a-15(f) and 15d-15(f) under the ExchangeAct) occurred during the fiscal quarter ended March 31, 2006 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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**Part II. OtherInformation**

**Item 1A.**                 Risk Factors

## **CertainFactors that May Affect our Future Results**

Therisks and uncertainties described below are not the only risks we face. Additionalrisks and uncertainties not presently known to us or currently deemedimmaterial may also impair our business operations. If any of the followingrisks actually occur, our financial condition and operating results could bematerially adversely affected.

***We expect to incur significant operating losses in the nearfuture***

We recorded netincome of $1,291,000 in the three months ended March 31, 2006 due to anon-recurring gain from the sale of our Optiwave 980 disposable manufacturingand development rights to Edwards. We expect to incur net losses during theremaining three fiscal quarters in the year ended December 31, 2006 andfor at least the next 12-24 months thereafter as we increase our spendingon an internal R&D initiative. Moreover, as we continue to pursue ourbusiness strategy of acquiring or developing new medical devices to addresscardiac and vascular related markets, we may continue to incur expenses thatexceed the revenues we generate. We cannot provide any assurance that we willbe successful with our business strategy, that any new products underdevelopment will be successful or that we will ever return to profitability.

***Our company is currently dependent on one principal productline to generate revenues***

We currently sellone principal product line, which consists of two patented high-powered carbondioxide lasers and related TMR disposable kits known as the Heart LaserSystems, which account for the majority of our total revenue. Approximately 97%and 89%, of our revenues in the three months ended March 31, 2006 and theyear ended December 31, 2005, respectively, were derived from the salesand service of our Heart Laser Systems. This absence of a diversified productline means that we are directly and materially impacted by changes in themarket for Heart Laser Systems.

***Our company is dependent on one principalcustomer***

Pursuantto the terms of our TMR distribution agreement with Edwards, Edwards is ourexclusive distributor for our HL2 TMR laser and TMR kits in the United States. Inaddition, we are the exclusive manufacturer of the current version of the Optiwave980 laser console for Edwards. As a result of these exclusive arrangements,Edwards accounted for 82% and 89% of our total revenues in the three monthsended March 31, 2006 and the year ended December 31, 2005,respectively, and we expect Edwards to account for the significant majority ofour revenue in the near future. If our relationship with Edwards does notprogress as anticipated, or if Edwards’ sales and marketing strategies fail togenerate sales of our products in the future, our revenue will decreasesignificantly and our business, financial condition and results of operationswill be seriously harmed.

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***Our ability to realize future revenues fromthe Optiwave 980 is dependent upon Edwards successfully launching this newproduct into an existing market with a new sales team***

Edwards has onlyrecently completed its marketing evaluations of the Optiwave 980 System and, asa result, has a limited amount of experience selling this new product into theU.S. market. Edwards must effectively train a new sales team to market theOptiwave 980 System and faces significant competition from several othercompanies that have been selling competitive non-laser based technologies forseveral years. We cannot assure you that Edwards will successfully commercializethe Optiwave 980 System or that we will ever receive any or all of the royaltyrevenue we negotiated to receive from the sale of disposable products under ourroyalty agreement with Edwards.

***Our company is dependent oncertain suppliers***

Some of the components for our Heart Laser Systems, most notably thepower supply and certain optics and fabricated parts for the HL2, and certaincomponents for the Optiwave 980 System, are only available from one supplier,and we have no assurance that we will be able to source any of our sole-sourcedcomponents from additional suppliers. We are dependent upon our sole suppliersto perform their obligations in a timely manner. In the past, we haveexperienced delays in product delivery from our sole suppliers and, because wedo not have an alternative supplier to produce these products for us, we havelittle leverage to enforce timely delivery. Any delay in product delivery orother interruption in supply from these suppliers could prevent us from meetingour commercial demands for our products, which could have a material adverseeffect on our business, financial condition and results of operations. Furthermore,we do not require significant quantities of any components because we produce alimited number of our products each year. Our low-quantity needs may notgenerate substantial revenue for our suppliers. Therefore, it may be difficultfor us to continue our relationships with our current suppliers or establishrelationships with additional suppliers on commercially reasonable terms, if atall, and such difficulties may seriously harm our business, financial conditionand results of operations.

***We are dependent upon our key personnel andwill need to hire additional key personnel in the near future***

Our ability to operate ourbusiness successfully depends in significant part upon the retention andmotivation of certain key technical, regulatory, production and managerialpersonnel and consultants and our ongoing ability to hire and retain additionalqualified personnel in these areas. Competition for such personnel is intense,particularly in the Greater Boston area. We cannot be certain that we will beable to attract such personnel and the loss of any of our current key employeesor consultants could have a significant adverse impact on our business.

***Our company may beunable to raise needed funds***

As of March 31,2006, we had cash, cash equivalents and short-term investments totaling$10,533,000. Based on our current operating plan, we anticipate that ourexisting capital resources should be sufficient to meet our working capitalrequirements for at least the next 12 months. However, if our business does notprogress in accordance with our current business plan, we may need to raiseadditional funds in the future. We may not be able to raise additional capitalupon satisfactory terms, or at all, and our business, financial condition andresults of 

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operations couldbe materially and adversely affected. To the extent that we raise additionalcapital by issuing equity or convertible securities, ownership dilution to ourshareholders will result. To the extent that we raise additional capitalthrough the incurrence of debt, our activities may be restricted by therepayment obligations and other restrictive covenants related to the debt.

***In order to compete effectively, our current and futureproducts need to gain commercial acceptance***

TMR and surgicalablation for cardiac arrhythmias are still both novel technologies. Our currentand planned future products may never achieve widespread commercial acceptance.To be successful, we and Edwards need to:

·                  demonstrate tothe medical community in general, and to heart surgeons and cardiologists inparticular, that TMR and surgical tissue ablation for cardiac arrhythmias areprocedures that are effective, relatively safe and cost effective;

·                  supportthird-party efforts to document the medical processes by which TMR proceduresrelieve angina and surgical tissue ablation cures cardiac arrhythmias;

·                  have more heartsurgeons trained to perform TMR procedures using the Heart Laser Systems andsurgical tissue ablation procedures using the Optiwave 980 System; and

·                  maintain andexpand third-party reimbursement for the TMR procedure.

To date, only alimited number of heart surgeons have been trained in the use of TMR using theHeart Laser Systems and cardiac tissue ablation procedures using the Optiwave980 System. We are dependent on Edwards to expand related marketing andtraining efforts in the U.S. for the use of our products.

The Heart LaserSystems have not yet received widespread commercial acceptance. We believe thatconcerns over the lack of a consensus view on the reason or reasons why a TMRprocedure relieves angina in patients who undergo the procedure has limiteddemand for and use of the Heart Laser Systems. Until there is consensus, ifever, of the medical processes by which TMR procedures relieve angina, webelieve some hospitals may delay the implementation of a TMR program.

If we are unableto achieve widespread commercial acceptance of the Heart Laser Systems or theOptiwave 980 System, our business, financial condition and results ofoperations will be materially and adversely affected.

***Our primary competitor in TMR may obtainFDA approval to market a new device, the impact of which is uncertain on thefuture adoption rate of TMR***

Ourprimary TMR competitor, CardioGenesis, is attempting to obtain FDA approval tomarket their “percutaneous” method of performing myocardial revascularization,previously known as PMR, and recently rebranded as PMC (percutaneous myocardialchanneling), which would provide a less invasive method of creating channels inthe heart. If PMC can be shown to be safe and effective and is approved by theFDA, it would eliminate the need in certain patients to make an incision in thechest, reducing costs and speeding recovery. It is unclear what impact, 

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if any, anapproval of a PMC device would have on the future adoption rate for TMRprocedures. If PMC is approved, it could erode the potential TMR market whichwould have a material adverse effect on our business, financial condition andresults of operations.

***Rapid technological changes in our industry could make ourproducts obsolete***

Our industry ischaracterized by rapid technological change and intense competition. Newtechnologies and products and new industry standards will develop at a rapidpace, which could make our current and future planned products obsolete. Theadvent of new devices and procedures and advances in new drugs and geneticengineering are especially concerning competitive threats. Our future successwill depend upon our ability to develop and introduce product enhancements toaddress the needs of our customers. Material delays in introducing productenhancements may cause customers to forego purchases of our products andpurchase those of our competitors.

Many potentialcompetitors have substantially greater financial resources and are in a betterfinancial position to exploit marketing and research and developmentopportunities. In addition, we are aware that other companies are developing oralready have developed proprietary systems for the treatment of cardiacarrhythmias, and specifically AF, that may be safer, clinically more effective,easier and more cost effective to use and, in the case of percutaneous devices,less invasive than the system we are developing.

***We must receive and maintain government clearances orapprovals in order to market our products***

Our products andour manufacturing activities are subject to extensive, rigorous and changingfederal and state regulation in the U.S. and to similar regulatory requirementsin other major international markets, including the European Union and Japan. Theseregulations and regulatory requirements are broad in scope and govern, amongother things:

·                  product designand development;

·                  product testing;

·                  productlabeling;

·                  product storage;

·                  premarketclearance and approval;

·                  advertising andpromotion; and

·                  product salesand distribution.

Furthermore,regulatory authorities subject a marketed product, its manufacturer and themanufacturing facilities to continual review and periodic inspections. We aresubject to ongoing FDA requirements, including required submissions of safetyand other post-market information and reports, registration requirements,Quality Systems regulations, and recordkeeping requirements. The FDA’s QualitySystems regulations include requirements relating to quality control andquality assurance, as well as the corresponding maintenance of records anddocumentation. Edwards, our distributor, depending on its activities, is alsosubject to certain requirements under the Federal Food, Drug, and Cosmetic Actand the regulations promulgated thereunder, and state laws and registrationrequirements covering the distribution of our products. Regulatory agencies maychange existing requirements or adopt new requirements or policies that couldaffect our regulatory responsibilities or the regulatory responsibilities of adistributor like 

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Edwards. We may beslow to adapt or may not be able to adapt to these changes or new requirements.

Later discovery ofpreviously unknown problems with our products, manufacturing processes, or ourfailure to comply with applicable regulatory requirements may result inenforcement actions by the FDA and other international regulatory authorities,including, but not limited to:

·                  warning letters;

·                  patient orphysician notification;

·                  restrictions onour products or manufacturing processes;

·                  voluntary ormandatory recalls;

·                  product seizures;

·                  refusal toapprove pending applications or supplements to approved applications that wesubmit;

·                  refusal topermit the import or export of our products;

·                  fines;

·                  injunctions;

·                  suspension orwithdrawal of marketing approvals or clearances; and

·                  civil andcriminal penalties.

Should any ofthese enforcement actions occur, our business, financial condition and resultsof operations could be materially and adversely affected.

To date, we havereceived the following regulatory approvals for our products:

***Heart Laser Systems***

*UnitedStates —*We received FDA approval to market the HL1 HeartLaser System in August 1998 and the HL2 Heart Laser System in January 2001.However, although we have received FDA approval, the FDA:

·                  has restrictedthe use of the Heart Laser Systems by not allowing us to market these productsto treat patients whose condition is amenable to conventional treatments, suchas heart bypass surgery, stenting and angioplasty; and

·                  could imposeadditional restrictions or reverse its ruling and prohibit use of the HeartLaser Systems at any time.

*Europe—*We received the CE Mark from the European Union for the HL1and HL2 in March 1995 and February 2001, respectively. However:

·                  our current ISOcertification (13485-1996) that enables us to apply the CE mark and shipour products into the EU will expire on July 31, 2006. We must conform ourquality system to a new ISO standard (13485-2003), undergo an audit andbe certified by our registrar prior to July 31, 2006, in order to be ableto continue to ship our products into the EU. We are currently in the processof implementing the necessary changes to our quality system in order to conformto the new ISO standard, however, 

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                        we cannot provide any assurancethat we will timely meet or maintain conformance to the requirements of the newstandard before July 31, 2006 or in the future;

·                  the EuropeanUnion could impose additional restrictions or reverse its ruling and prohibituse of the Heart Laser Systems at any time; and

·                  France hasprohibited, and other European Union countries could prohibit or restrict, useof the Heart Laser Systems.

*Japan—*We cannot market our product in Japan until we receivegovernment approval.

Prior to marketingthe Heart Laser Systems in Japan, we must receive approval from the Japanesegovernment. This approval requires a clinical study in Japan with at least 60patients. A study was completed in 1998 with the HL1. Although the results ofthis study have been submitted to the Japanese government, we do not knowwhether the clinical study will be sufficient or when, if ever, we will receiveapproval to sell the HL1 in Japan. In addition, it is unclear what impact theintroduction of the HL2 into the U.S. and other international markets will haveon our ability to market the HL1 in Japan.

***Optiwave 980 System***

*United States —*The FDA has given clearance to the Optiwave980 System through the 510(k) premarket notification process withindications for use as a surgical instrument for coagulation of soft tissue,including cardiac tissue, in conjunction with or without endoscopic equipmentin the contact or non-contact mode in open or closed surgical procedures.

Although the Optiwave 980 System has received clearance from the FDAonly for the indications of use stated above, physicians, under the practice ofmedicine exception, may use the device in any manner they choose in treating anindividual patient, including using the device to treat patients with AF. However,neither we nor Edwards have conducted any clinical trials designed to obtaindata to submit to the FDA for the purpose of obtaining a specific indicationfor use of the Optiwave 980 System that would allow Edwards to make claims orotherwise market this device for the treatment of AF. We are aware of severalother companies that have announced their plans to conduct clinical trials insupport of a labeling claim that would allow them to market their devices forthe treatment of AF if clearance is obtained from the FDA.

In the event these other competitors are successful in obtainingspecific indications of use for their devices in the treatment of AF, theOptiwave 980 System may be at a competitive marketing disadvantage until suchtime, if ever, that Edwards conducts a clinical trial, submits sufficient datato the FDA by means of a new 510(k) and obtains clearance to market theOptiwave 980 System for the treatment of AF. We cannot provide any assurancethat Edwards will ever conduct such a clinical trial or, if they do, that thedata they obtain and submit to the FDA will be sufficient for the FDA to expandthe current indications of use and provide clearance for the Optiwave 980System to be marketed for the treatment of AF. Also, we cannot assure you thateven if such clearance is obtained, that it will be obtained in a timely enoughfashion for our products to remain competitive in the marketplace.

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*Europe —*The Optiwave 980 System cannot be marketed in the EU until such time asit receives CE Mark approval. Edwards needs to complete and submit the relevanttechnical documentation to the appropriate certifying body in order to be ableto apply the CE Mark to the product. If approval to apply the CE Mark isgranted, the Optiwave 980 System will then be able to be distributed in the EU.

*** Changes in third party reimbursement foreither TMR or cardiac tissue ablation procedures could materially affect futuredemand for our products***

Demand for medical devices is often affected by whether third partyreimbursement is available for the devices and related procedures. CurrentlyMedicare coverage is provided for TMR when it is performed as a sole therapytreatment. In addition, when two or more medical procedures are performed incombination with each other, Medicare rules generally allow hospitals tobill for whichever of the two procedures carries the higher reimbursementamount. Therefore, in situations where sole therapy TMR reimbursement ratesexceed that provided for bypass surgery alone, if hospitals perform acombination procedure where both bypass surgery and adjunctive TMR areperformed on a patient, the hospital is able to bill for the higher TMRprocedure reimbursement payment. In these instances, the doctor also can billan additional amount for performing multiple procedures.

Certain private insurance companies and healthmaintenance organizations also currently provide reimbursement for TMRprocedures performed with our products and physician reimbursement codes have beenestablished for both surgical procedures; however, we have limited data as tothe breadth of this coverage for the TMR procedure by private insurancecompanies and health maintenance organizations.

Cardiac tissueablation procedures, such as those that are expected to be performed using theOptiwave 980 System, are also currently reimbursed by Medicare when performedas a sole therapy. In instances where a surgeon might perform a cardiac tissueablation procedure in combination with another heart related procedure, such asa valve replacement or repair, we believe the other procedure will normally carrya higher reimbursement and, therefore, will be the procedure that the hospitalbills to Medicare.

Noassurance can be given, however, that these payers will continue to reimbursehealthcare providers who perform TMR or cardiac tissue ablation proceduresusing our products now or in the future. Further, no assurance can be giventhat additional payers will reimburse healthcare providers who perform TMR orcardiac tissue ablation procedures using our products or that reimbursement, ifprovided, will be timely or adequate. In addition, the market for our productscould be adversely affected by future legislation to reform the nation’shealthcare system or by changes in industry practices regarding reimbursementpolicies and procedures.

Shouldthird party insurance reimbursement for either TMR or cardiac tissue ablationprocedures be reduced or eliminated in the future, our business, financialcondition and results of operations would be materially and adversely affected.

***Asserting and defending intellectual property rights mayimpact our results of operations***

In our industry,competitors often assert intellectual property infringement claims against 

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one another. The successof our business depends on our ability to successfully defend our intellectualproperty. Future litigation may have a material impact on our financialcondition even if we are successful in marketing our products. We may not besuccessful in defending or asserting our intellectual property rights.

An adverse outcomein any litigation or interference proceeding could subject us to significantliabilities to third parties and require us to cease using the technology thatis at issue or to license the technology from third parties. In addition, afinding that any of our intellectual property is invalid could allow ourcompetitors to more easily and cost-effectively compete with us. Thus, anunfavorable outcome in any patent litigation or interference proceeding couldhave a material adverse effect on our business, financial condition or resultsof operations.

The cost to us ofany patent litigation or interference proceeding could be substantial. Uncertaintiesresulting from the initiation and continuation of patent litigation orinterference proceedings could have a material adverse effect on our ability tocompete in the marketplace. Patent litigation and interference proceedings mayalso absorb significant management time.

***We may be subject to product liability lawsuits; ourinsurance may not be sufficient to cover damages***

We may be subject toproduct liability claims. Such claims may absorb significant management timeand could degrade our reputation and the marketability of our products. Ifproduct liability claims are made with respect to our products, we may need torecall the implicated product which could have a material adverse effect on ourbusiness, financial condition and results of operations. In addition, althoughwe maintain product liability insurance, we cannot be sure that our insurancewill be adequate to cover potential product liability lawsuits. Our insuranceis expensive and in the future may not be available on acceptable terms, if atall. If a successful product liability claim or series of claims exceeds ourinsurance coverage, it could have a material adverse effect on our business,financial condition and results of operations.

***We are subject to risks associated with internationaloperations***

A portion of ourproduct sales are generated from operations outside of the U.S. Establishing,maintaining and expanding international sales can be expensive. Managing andoverseeing foreign operations are difficult and products may not receive marketacceptance. Risks of doing business outside the U.S. include, but are notlimited to, the following: agreements may be difficult to enforce andreceivables difficult to collect through a foreign country’s legal system;foreign customers may have longer payment cycles; foreign countries may imposeadditional withholding taxes or otherwise tax our foreign income, imposetariffs or adopt other restrictions on foreign trade; U.S. export licenses maybe difficult to obtain; and the protection of intellectual property rights inforeign countries may be more difficult to enforce. There can be no assurancethat our international business will grow or that any of the foregoing riskswill not result in a material adverse effect on our business or results ofoperations. Our international sales have declined since 2003.

 

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***We will soon have to comply withinternal controls evaluations and attestation requirements***

Pursuantto Section 404 of the Sarbanes-Oxley Act of 2002, we will be required,beginning with our fiscal year ending December 31, 2007, to perform anevaluation of our internal controls over financial reporting and have ourindependent registered public accounting firm attest to such evaluation. We aredeveloping a program to perform this evaluation in order to comply with theserequirements. Compliance with these requirements is expected to be expensiveand time-consuming. If we fail to timely complete this evaluation, or if ourindependent registered public accounting firm cannot timely attest to ourevaluation, we could be subject to regulatory action and public confidence inus could be adversely affected and our stock price could decline. In addition,any failure to implement required new or improved controls, or difficultiesencountered in their implementation, could harm our operating results or causeus to fail to meet our reporting obligations.

***Because we are incorporated in Canada, youmay not be able to enforce judgments against us and our Canadian directors***

Under Canadianlaw, you may not be able to enforce a judgment issued by courts in the U.S.against us or our Canadian directors. The status of the law in Canada isunclear as to whether a U.S. citizen can enforce a judgment from a U.S. courtin Canada for violations of U.S. securities laws. A separate suit may need tobe brought directly in Canada.

***Our stock price hashistorically fluctuated and may continue to fluctuate significantly in thefuture which may result in losses for our investors***

Our stock pricehas been and may continue to be volatile. Some of the factors that can affectour stock price are:

·                  the announcementof new products, services or technological innovations by us or ourcompetitors;

·                  actual oranticipated quarterly increases or decreases in revenue, gross margin orearnings, and changes in our business, operations or prospects;

·                  speculation oractual news announcements in the media or industry trade journals about ourcompany, our products, the TMR or cardiac ablation procedures or changes inreimbursement policies by Medicare and/or private insurance companies;

·                  announcementsrelating to strategic relationships or mergers;

·                  conditions ortrends in the medical device industry;

·                  changes in theeconomic performance or market valuations of other medical device companies;and

·                  general marketconditions or domestic or international macroeconomic and geopolitical factorsunrelated to our performance.

***The market price of our stock may fall if shareholders selltheir stock***

Certaincurrent shareholders hold large amounts of our stock, which they could sell inthe public market from time to time. Sales of a substantial number of shares ofour common stock within a short period of time could cause our stock price tofall. In addition, the sale of these shares could impair our ability to raisecapital through the sale of additional stock.

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*** ***

***We have no intention to pay dividends***

Wehave never paid any cash dividends on our common stock. We currently intend toretain all future earnings, if any, for use in our business and do not expectto pay any dividends in the foreseeable future.

**Item 6.          Exhibits**
| 10.1+  |   | Supply Agreement, dated March 9, 2006, by and  among the Registrant, PLC Medical Systems, Inc. and Edwards Lifesciences  LLC.                                                                                         |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                            |
| 10.2+  |   | Letter Agreement, dated March 9, 2006, between  the Registrant, PLC Medical Systems, Inc. and Edwards Lifesciences LLC.                                                                                               |
|   |   |                                                                                                                                                                                                                            |
| 10.3   |   | Second Amendment to Shareholders Agreement, dated  April 6, 2006, by and among the Registrant and Edwards Lifesciences  Corporation.                                                                                       |
|   |   |                                                                                                                                                                                                                            |
| 31.1   |   | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) or Rule 15d-14(a) of the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |
|   |   |                                                                                                                                                                                                                            |
| 31.2   |   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) or Rule 15d-14(a) of the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |
|   |   |                                                                                                                                                                                                                            |
| 32.1   |   | Certifications pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                            |
|   |   |                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                            |

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+                    Confidential treatmentrequested as to certain portions, which portions have been omitted and filedseparately with the Securities and Exchange Commission.

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                               | PLC  SYSTEMS INC. |
|-------------------------------|-------------------|
|                          |              |   |
|                          |              |   |
| Date:  May 15, 2006 | By:               | /s/ James G. Thomasch |
|                          |              | James G. Thomasch |
|                          |              | Chief Financial Officer   (Principal Financial Officer and Chief Accounting Officer) |

 

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**EXHIBITINDEX**
| Exhibit  Number | ** ** | **Description of Document**                                                                                                                                                                                           |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **      | ** ** | ** **                                                                                                                                                                                                            |
| 10.1            | +          | Supply Agreement, dated March 9, 2006, by and  among the Registrant, PLC Medical Systems, Inc. and Edwards Lifesciences  LLC.                                                                               |
|            |       |                                                                                                                                                                                                                  |
| 10.2            | +          | Letter Agreement, dated March 9, 2006, between  the Registrant, PLC Medical Systems, Inc. and Edwards Lifesciences LLC.                                                                                     |
|            |       |                                                                                                                                                                                                                  |
| 10.3            |       | Second Amendment to Shareholders Agreement, dated  April 6, 2006, by and among the Registrant and Edwards Lifesciences  Corporation.                                                                             |
|            |       |                                                                                                                                                                                                                  |
| 31.1            |       | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) or 15d-14(a) of the Securities  Exchange Act of 1934, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|            |       |                                                                                                                                                                                                                  |
| 31.2            |       | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) or 15d-14(a) of the Securities  Exchange Act of 1934, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|            |       |                                                                                                                                                                                                                  |
| 32.1            |       | Certifications pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                  |

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+                    Confidentialtreatment requested as to certain portions, which portions have been omittedand filed separately with the Securities and Exchange Commission.

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